Federal Reserve & Interest Rates

Governor Randall S. Kroszner speaks for the Federal Reserve Board on the matter. The Office of Thrift Supervision and the Federal Deposit Insurance Corporation (FDIC) have worked together with the Federal Reserve since 1999 researching and proposing policies for a replacement of Basel I.

It is because of the fact that Basel I has become outdated, that the need has risen to change the policy. Initially, when Basel I was implemented, in 1988, corporate loans, consumer credit, and residential mortgages were regulated quite generally. Over the passed 19 years, the economy has evolved, and the need for a more detailed policy regarding the varied risks involved in these types of credit emerged.

In a passed discussion on Basel II, Governor Kroszner pointed out the three main problems with Basel I. “(1) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, (2) all unsecured consumer credit card exposures are treated equivalently, and (3) almost all first-lien residential mortgage exposures are deemed equally risky” He explained that this was creating “perverse incentives” for banks to take on higher risks than they would under different policy.

More recently, Basel II was taken through the final United States rule for implementation. The adapted Basel II will enhance the risk-sensitivity of monetary policy and create a system that more effectively assesses creditworthiness of borrowers. Kroszner believes that better risk management practices and tools “will contribute to a more resilient financial system as a whole.”

It is the responsibility of core banks to begin implementing what is now know as the “Three Pillars of Basel II.” The first pillar divides the bank’s risk assessment into three categories, which are credit risk, operational risk, and market risk. The second pillar includes a supervisory review of the main risk assessments of pillar one, and a more detailed look at other types of risk, such as liquidity risk, reputation risk, and legal risk. The third pillar requires an increased disclosure or all of their risk assessment practices, to ensure that risk management is dealt with properly.

The full implementation of Basel II is still underway, and it was important to note the milestone in the process that has been reached. A slow and partial implementation of the policy will continue, and the Federal Reserve will be monitoring it closely for any adjustments that may be needed.